Bulge-bracket broker Morgan Stanley has launched a new algorithmic trading product, Morgan Stanley Fix, to address institutional investor demand for more accurate execution benchmarking of their FX trades.
Morgan Stanley Fix provides institutional clients with flow-weighted average pricing (FWAP) in currencies. Similar to volume-weighted average pricing (VWAP) in exchange-traded markets, FWAP is used to minimise the chance of trading on extreme prices over an execution window.
“Custodians tend to handle the FX part of international security transactions as part of their standing instructions,” said Paul Aston, executive director at Morgan Stanley. “But increasingly large international equity buy-side clients are using dealers and other sources of liquidity beyond the custodian.”
However if buy-side firms do not manage currency transactions carefully, they are at risk of incurring additional cost. “If a US fund manager buys a European stock which is settled in euro, it immediately incurs FX risk at the time of the underlying security transaction because the exchange rate can drift before the currency transaction is implemented. If the currency price moves in the wrong direction, the entire trade can become more expensive,” said Aston.
Morgan Stanley's Quantitative Solutions and Innovations (QSI) Group has devised a specific methodology for the Morgan Stanley Fix product to help the institutional investor determine fair price in the FX market, which including a transaction cost analysis (TCA) framework.
“There are two sources of execution risk a currency trade must manage – volume and price.
Buy-side traders need to worry about relative volume to scale the notional size of their transactions to minimise market impact and spread costs. Our system provides traders with an estimate of the relative depth of liquidity at any point on an average day,” Aston explained. “We call these estimates ‘intra-day liquidity cycles’ and we have found that distribution of these cycles throughout the day tends to be fairly stable. We update the intra-day liquidity cycles monthly, so that they remain current and reflect any seasonal biases in liquidity flows. We make these cycles available to investors to help provide greater transparency with respect to currency market volume.”
As prices are difficult to forecast, currency volatility is used in the calculation instead, which is relatively stable.
“Products that address transaction costs in FX are a necessary tool for international investment managers and traders seeking best execution in the foreign exchange markets,” said Aston.
To meet the overall TCA demands of institutional clients, Morgan Stanley Fix is supported by various pricing tools developed by Morgan Stanley's QSI Group, including: pre-published intra-day liquidity cycles used to proportionately slice Morgan Stanley Fix orders over the execution window; a transaction cost calculator to assess spread cost and potential market impact pre-trade using observable factors; historical time-series of daily FWAP prices for back testing; and TCA execution reports.